How Traders Are Playing Turbulent Japan Markets

Pedestrian are reflected in an electronic stock board in Tokyo, Japan, on Friday, May 24, 2013.

As Japan finishes a tough week, options traders are loading on the bearish bets.

One of the most actively traded equity options on Friday are the Japan Index ETF September 13-strike calls. These are being sold aggressively for $0.13, with more than 32,000 trading as of 12 p.m. EDT. The iShares MSCI Japan Index ETF (ticker symbol: EWJ) tracks the Japanese stock market, which has experienced unprecedented volatility this week, and this is a somewhat bearish bet that the EWJ will stay below $12.87 through September expiration.

At its highs on Wednesday, the EWJ was up 24 percent year-to-date, in a rally driven by the Bank of Japan's massive stimulus plan. But on Thursday, unexpectedly hawkish comments from Federal Reserve Chairman Ben Bernanke unsettled some traders. In addition, the Chinese Flash PMI came in lower than expected, and fell into contraction territory. This caused a run for the exits, and Japan's Nikkei closed down 7 percent on the day. On Friday, the volatility continued, with the index initially rallying 4 percent, only to fall 7 percent from its intraday high.

A correction was long overdue in Japan, but the speed of the move has nevertheless caused some panicked selling. This appears to be the beginning of a volatile correction in the Japanese markets, but I would expect it to prove to be a fantastic buying opportunity by the end of the summer. The price action appears similar to that in the S&P 500 following the flash crash, which, in retrospect, provided a great buying opportunity in the weeks after.

Retail Investors Will Come Back into Nikkei: Pro

Jens Nordvig, global head of currencies at Nomura Securities, tells CNBC there were three things that played in the huge drop in the Nikkei.

I remain long-term bullish on Japan, because despite this week's comments, the Fed continues to be on hold, and a tapering of qualitative easing is far from a sure thing this summer. Likewise, the Bank of Japan and European Central Bank stimulus polices are not going anywhere anytime soon. A weaker yen is already boosting corporate profits in Japan, and a revitalized Japanese economy will continue to drive the Nikkei and the EWJ higher.

Because I see the potential for Japanese markets to rip back to new highs this summer, I would not be a call seller here. Instead, if I was worried about a preexisting long EWJ position, I would look at put spreads for an economical way to reduce downside risk. The key is to hedge enough so that you do not feel compelled to join the panic selling that has gripped the market over the past two days. If you can stomach the volatility and stick with the trade, I believe you will be rewarded later in the year.

Of course, you might not already be in the trade. I have been waiting for a pullback in the Japanese markets, and my plan now is to throw in a bid below the market and hope I get hit on it. The upside-call selling doesn't necessarily tell me that the panic selling over the last two days will last forever, and although a new high might not be made this summer, I may have time to work a bid somewhere lower that will allow me to get upside exposure after the summer months.

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